MEMORANDUM SUBMITTED BY THE INSTITUTE
FOR FISCAL STUDIES (CP 22)
SUMMARY
A contributory system comprises two sets of
rules. The contribution rules determine how individuals establish
a contribution history. The payment rules determine benefit payments
given a particular contribution history.
In the National Insurance system, changes to
the contribution rules have tended to widen the circumstances
in which individuals establish a contribution history. In particular,
there has been a move away from reliance on monetary contributions.
Changes to the payment rules have, over the last 20 years, reduced
the generosity of the benefits available to those with a given
contribution history. Payment rules throughout the benefits system
are now tending to focus relatively more on current income or
health status and relatively less on previous contributions.
Any case for a return to a benefit system more
focused on previous contributions needs to make clear what such
a system is intended to achieve. The private sector does not as
yet provide a full range of insurance products against unemployment
and sickness or disability, leaving a possible role for the state
as insurance provider. But the private sector does provide pension
income for old age. In pension provision, the main role for contributory
benefits is in redistributing towards those with low lifetime
incomes.
The desire to avoid blunting the financial incentives
to work and save might be advanced as reasons for favouring a
contributory system of benefits over a means-tested one. But,
fundamentally, such concerns are about means-testing—they
are not directly related to the contributory principle. Indeed,
it is quite possible that a benefit system which was principally
contributory could produce these disincentives, and equally possible
to think of design for a system with no contributory element which
avoided them.
One of the areas most in need of attention within
the current contributory system is the overlap between health
benefits and the labour market—it is not clear why we maintain
a benefit that is a contingent on current health and previous
contributions. In addition, the political risks associated with
the potential that future governments may alter payment rules
need to be reduced, probably through the provision of more transparent
information on current entitlements. Finally, there is a need
to assess whether there is any role for a contributory benefit
in the labour market. The contributory element of Jobseekers Allowance
is basically a historical hangover from the original National
Insurance system.
THE CONTRIBUTORY
PRINCIPLE IN
NATIONAL INSURANCE
What is the contributory principle?
1. All social security benefits are paid
contingent on the recipient falling into a particular category.
For example, Disability Living Allowance (DLA) is paid contingent
on a person's current health status and Income Support is paid
contingent on a person's current income. One of the defining features
of a contributory benefit is that payments are contingent on events
that occurred prior to the claiming of the benefit. For example,
Contributory Jobseekers Allowance (Contributory JSA) is only available
to those out of work who had previously been working and
paying National Insurance Contributions (NICs). A contributory
system therefore contains two fundamental sets of rules—the
contribution rules that give rise to a contribution record and
the payment rules which determine the benefit payments given a
particular contribution record.
Contribution rules
2. The rules for establishing a contribution
record were, in Beveridge's system, extremely simple. Virtually
all paid workers made contributions, which consisted of flat rate
payments. As benefits were also flat rate, there was a very clear
link between work, contributions and benefits. There have been
two major changes which have altered this simple relationship:
3. Earnings related contributions: these
were introduced in 1961, extended in 1975 and again in 1985. Most
recently, the current Chancellor announced the abolition of the
"entry fee", leaving the flat rate element of NICs entirely
superseded by earnings-related contributions for all but the self
employed.
4. Non-monetary contributions. Since
1975 contribution histories have been credited to individuals
in certain circumstances, such as caring for a young child or
disabled person. From April 2000, the LEL will be increased creating
a new group making non-monetary contributions. These will be people
with earnings between the old and new levels of the LEL. Those
with earnings below the old LEL will remain outside the National
Insurance system.
5. The earnings related changes to National
Insurance have left the system operating much more like an ordinary
income tax than like the initial flat rate contribution system.
For most benefits, higher contributions do not lead to increased
levels of benefit entitlement. The extension of credits within
the system has reduced the simple equation between being in work,
contributing and benefit entitlement, which the 1948 system entailed.
The current system is "contributory" only in a much
broader sense than that envisaged by Beveridge.
Benefit Payment rules
6. The second set of rules in a contributory
system are the payment rules, which determine the current benefit
entitlement of a person with a particular contribution record.
In the current National Insurance system these rules are highly
complex. Rather than examine the individual rules, we draw out
the essential themes that one might find in a contributory system.
7. Current contingency. In all cases,
National Insurance benefits are dependent on the claimant falling
into a particular category at the time of payment. The most important
of these contingencies are old age, unemployment and sickness
or disability. The payment rules may also involve a means-test
based on current income. [1]
8. Length of contribution history. The
level of payment of many National Insurance benefits, such as
the Basic State Pension, is related to the amount of time that
an individual has met the contribution rules.
9. Relationship with monetary contributions.
The State Earnings Related Pension Scheme (SERPS) is currently
the only National Insurance benefit where the level of benefit
is related to the level of monetary contributions that have been
made. SERPS is due to be replaced by the State Second Pension
(SSP) from April 2002. Payments of SSP will initially be partially
related to monetary contributions, but the pensions Green Paper
envisages that within five years of its start-up SSP will cease
to be earnings related.
Historic instability of payment rules
10. While the combination of the contribution
and payment rules determine actual benefit entitlement, there
is no fixed relationship between payments and contributions. Over
time, one of the most notable feaures of the National Insurance
system has been the degree of variability in the payment rules
that have not been reflected in the contribution rules. In the
past 20 years, changes in the rules have almost exclusively led
to a reduction in the amount of benefit that is payable given
a particular contribution history. These changes have been effected
by a variety of means:
11. Changes in benefit rates. The
single most important change affecting the level of National Insurance
benefits was the removal of earnings indexation in 1980, which
has had the compound effect of sharply reducing the relative value
of National Insurance benefits.
12. Changes to earnings related components.
After the introduction of SERPS in 1975, extensive changes
in 1988 and 1997 significantly reduced the generosity of the scheme.
In addition, earnings related components were introduced into
Unemployment Benefit in 1966 but removed in the early 1980s.
13. Changes to rules on current contingencies.
For Invalidity/Incapacity Benefit, there have been successive
changes to the health tests that must be met in order to qualify
for the benefit. Additionally, certain forms of current income
have been taken into account in accessing payment levels. For
Unemployment Benefit/Contributory JSA, entitlement has been reduced
for those in receipt of occupational pensions since 1980. This
provision is due to be extended to Incapacity Benefit.
14. Changes in the tax treatment of
benefits. A number of benefits have moved from being untaxed
to being taxed. For example, Invalidity Benefit was not subject
to taxation, but its successor, Incapacity Benefit does become
taxable after 28 weeks of receipt.
15. A further change that will affect levels
of benefit receipt is the increase in the pensionable age for
women, in alignment with that for men, due to be phased in from
2010. This will inevitably reduce the value of state retirement
benefits to women.
Contributory benefits within the social security
system
16. While the changes to payment rules for
contributory benefits have tended to reduce their value, the importance
of other elements of the benefit system has tended to increase.
The overall thrust of policy in the last 20 years has been a move
away from contributory benefits towards means-tested benefits.
The graph illustrates this trend in terms of the growing importance
of means-tested benefits and health-contingent benefits as a source
of income for disabled people.
Health-contingent benefits include
Attendance Allowance, Mobility Allowance, Disability Living Allowance
and Severe Disablement Allowance.
Contributory benefits include Incapacity Benefit and its
predecessors (Sickness Benefit and Invalidity Benefit).
Means-tested benefits are Income Support payments to disabled
people.
Source: Social Security Statistics, various years.
17. These trends are set to continue. Partial
means-testing and a tightening of the contribution rules are planned
for Incapacity Benefit, while Income Support premiums for the
severely disabled have been increased.
The future of the contributory principle
18. In the context of a fixed level of resources
for social security payments, any change in the method of allocation
must involve redistribution from one group to another. Any movement
which reduces the degree to which benefit levels are determined
by current income (means-testing) will imply a reduction in targeting
on the poor.
19. Of course, most changes to the benefit
system do not involve large initial redistribution. But large
scale redistribution often comes about through the accumulation
of the effects of changes over the longer term. So, while a "big
bang" reorganisation of the system is unlikely, a change
in the direction in which current policy is moving might be an
attractive option.
20. If a case is to be made for future development
of the contributory principle, one must be clear what this principle
is intended to achieve. Here we briefly examine the main arguments
for contributory benefits.
21. Correct for market failures. One
of the main forces behind the establishment of contributory benefits
was the failure of the market to provide insurance against certain
contingencies. While this may have been the case for pensions
fifty years ago, the rapid growth of occupational and personal
pensions have demonstrated that the market is now able to provide
annuitised income in old age. The market does not, as yet, provide
a full range of insurance products against unemployment or sickness
and disability.
22. Redistribution. The main argument
for the provision of contributory pension benefits is that these
can be used to redistribute resources to those with low lifetime
incomes. This is the main role for the proposed Second State Pension,
which will provide a better return on contributions for those
with low incomes than would be available through private sector
provision.
23. Incentives to meet contingent status.
At the margin, contribution rules will affect peoples's decisions
on whether to move into a status which generates a contribution
record. The size of the effect depends on how people value the
contribution record. However, for most states covered by the present
contribution rules, the impact of the extistence of contribution
rules on people's decisions is likely to be minimal.
24. The discussion of contributory benefits
can become confused by a number of issues which actually have
very little to do with the contributory principle. Rather, they
are problems related to means-testing and have a bearing on the
appropriate role for contributory benefits only in so far as contributory
rules in a benefit system are viewed as a substitute for rules
based on means-testing. The extent to which the two types of rule
substitute for one another is limited, both by the possibility
of a contributory system which incorporates means-testing, and
by the recognition that there are alternatives to means-tested
benefits which do not invoke the contributory principle, such
as benefits like DLA that are conditional on health status only.
Specific issues include:
25. Financial incentives to work. For
the unemployed, the withdrawal of benefits on moving into paid
employment reduces the financial incentives to work. The scale
of the problem increases if the value of out-of-work benefits
is high relative to the wage an individual expects to receive.
This is true whether or not the benefits have a contributory element
to their payment rules. Contributory benefits such as Incapacity
Benefit and Contributory JSA that are withdrawn completely once
a person enters employment can cause even larger unemployment
traps than entirely means-tested benefits which are withdrawn
via a taper as income rises.
26. Incentives to save. While the
promotion of the incentive to save is sometimes cited as a reason
to favour contributory benefits, disincentives to save are generated
by the inclusion of the current level of savings in the payment
rules of a benefit. This will be true whether or not the payment
rules also depend on a contribution record.
27. Takeup of benefits. Low takeup
of benefits is associated with high costs of claiming relative
to the value of the payment, and also with the stigma that might
be associated with certain benefits. Benefits that are means-tested
on current income tend to suffer from low takeup as the payment
rules are complicated, and because they involve high degree of
intrusion into the claimant's circumstances. These problems exist
whether or not the payment rules also include a contributory element.
28. Any reassessment of the future of contributory
benefits must consider a number of areas in need of urgent attention.
These include:
29. Overlap of sickness and labour market
benefits. Most health related benefits are provided solely
on the basis of current health status. The main exception is Incapacity
Benefit, which is dependent on both current health status and
previous employment history. The system may have been sensible
in a world of families with one—usually male—breadwinner,
whose incapacity would have resulted in a disproportionate reduction
of the family's standard of living compared to the incapacity
of the other partner. The system is increasingly less justifiable
as traditional labour market patterns have broken down, and the
benefit no longer provides anything approaching a replacement
for earnings for most people. In addition, the fact that the benefit
is withdrawn completely if the claimant moves into employment
produces large disincentives to individuals moving back into work.
30. Political risk of contributory benefits.
The potential benefits in a contributory system can be reduced
by future governments. This "political risk" has been
most notable in the case of SERPS, where entitlement has twice
been sharply reduced as a result of changes to the payment rules.
If the SSP is to be seen as an alternative to private provision
for those with low incomes, then it must not be subject to such
risks. At a minimum, those contributing to the scheme should receive
regular notice of their accrued rights which would make transparent
any reduction implemented by future policy changes.
31. Role of Contributory JSA. This
benefit replaced Unemployment Benefit in 1996. It pays a small
amount to those with sufficient contributions for a six month
period. The benefit no longer provides even a modest level of
earnings replacement for the majority of individuals, and most
redistribution to the unemployed is achieved by the means-tested,
non-contributory element of JSA.
The existence of Contributory JSA seems to be
an historic hangover from the original Unemployment Benefit in
the Beveridge system. There is now a need to decide what, if anything,
can be achieved by a contributory benefit in the labour market
and to design a new benefit which is capable of delivering those
objectives.
May 1999
1 It is important to note that the usual distinction
between "contributory benefits" and "means-tested
benefits" is merely a convenient short-hand. There is no
logical distinction between the two types of benefit and it is
perfectly possible for a benefit to have payment rules which depend
on a contribution record and on the level of current income (as
in the present reforms proposed for Incapacity Benefit). Back
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